Joel Greenblatt: "The Little Book that Beats the Market" | Talks at GoogleFeb 27, 2020
SPEAKER: Joel Greenblatt, our guest today, is the co-founder, CEO and co-CIO of Gotham Asset Management. We couldn't be more excited and grateful that he accepted our invitation and was here. Thank you very much Joel, it's on to you. JOEL GREENBLATT: Thank you very much. Thanks for coming today. I really appreciate it a lot. I've never been here before so I'm looking forward to my tour right after so thank you. So even Warren Buffett says that the vast majority of people should index, and I agree with him. So, are there any questions or do I have time?
On the other hand, well, I have time, so Warren Buffett doesn't index and neither do I. So I thought I'd tell you why, and then maybe you'll have more information to decide for yourself what makes sense to you. And in a sense, it shouldn't be that hard. In fact, I had a friend who is an orthopedic surgeon and he runs a group of orthopedic surgeons. And he asked me to speak to you at a dinner, about the stock
market. And I said, OK, these are smart, educated guys. They can understand these things. And I talked for like 35 minutes, explaining how the exchange worked and everything else.
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joel greenblatt the little book that beats the market talks at google...
And then I started getting questions like, oil was down $2 yesterday... what do I do? Or a
marketwent up 2% yesterday, what do I do about it? So my interpretation of those questions was that I had just crashed and burned. So last year I was lucky enough to be asked to teach a 9th grade class, a group of kids, mostly from Harlem. And I had just hit and burned with orthopedic surgeons, and I didn't want to do that with the kids. So I started trying to think, what could I do to explain the stock market a
So I walked into class the first day and handed out a bunch of three by five cards. And I brought this jar of jelly beans right here, and I asked... the students passed around the jar of jelly beans. I asked them to count the rows, do whatever they wanted, and write their best estimate of how many candies were in the jar. I picked up the three by five cards, then walked around the room, one by one, to each of the children in the room. And I said, listen, you can keep your assumption or you can change your assumption.
That depends on you. And I went, one by one, around the room and asked people how many, and wrote down the various guesses. It turned out that the average guess for the three-by-five cards was 1,771 jelly beans. There are 1,776 jelly beans in the jar, so it was pretty good. Guess when I went around the room, that was 850 jelly beans. And I explained to them that the stock market is actually challenged, because everyone knows what they just read in the paper or what the guy next to them said, what they saw on the news, and they're influenced by everything around them.
And that was the second guess, and that's the stock market. The cold, calculating guess, when they were counting rows and trying to figure out what was going on, that was actually the best guess: that's not the stock market. But that's where I see our opportunity. Once a year in my class at Columbia, at least for the last five or six years, someone raises their hand and asks a question that goes something like: hey Joel, congratulations. You've been doing this for 35 years and you've had a good track record. But now there are more computers, there is more data, there is more capacity to crunch numbers.
And isn't the party over for us? Isn't it just more hedge funds? It's just a lot more competition. Isn't the party over for us? So my students are generally second year MBAs. I would say they have an average age of 27 or so. So I just answer this way. I tell you, let's go back to when you learned to read. Let's take a look at the most followed market in the world. That would be the United States. Let's take a look at the most followed stocks within the world's most followed market. That would be the S&P 500 stock.
Let's take a look at what's happened since you learned to read. So I tell you, from 1997, when they were 9 or 10 years old, to 2000, the S&P 500 doubled. From 2000 to 2002, it was cut in half. From 2002 to 2007 it doubled. From 2007 to 2009, it was cut in half. And from 2009 to today, it's roughly tripled, which is my way of telling you that people are still crazy. That was just the last 17 years. And I'm understating the case, because the S&P 500 is an average of 500 stocks. If you lift the lids and look below what's going on, there's a wide spread of those 500 stocks between those who, at any given time, are in favor and those who are not.
And then there's a wild ride under the covers. If you look under the covers, there's a wild ride of those 500 shares at any one time. And that doubling and halving, doubling and halving with the 500-share average really smooths the way. So there should be a chance. And if you understand what stocks are... and I guarantee my students the first day of school... I make a guarantee every year. And they walk in, and I guarantee this: if they do a good job of valuing a company, I guarantee that the market will agree with them. I just never tell them when.
It could be a couple of weeks. It can be two or three years. But if they do a good job of valuing, the market will agree with them. Actions are not pieces of paper that bounce up and down and are assigned complicated proportions, like Sharpe proportions or Sortino proportions. Stocks are shares owned by businesses that you are valuing and, if you so choose, tried to buy at a discount. So if you believe what Ben Graham said, that this horizontal line is fair value, and this wavy line around that horizontal line is stock prices, and you have a disciplined process to buy, perhaps more than your fair share when they are below the line and if you want to sell or short more than your fair share when they are above the line, the market throws us all the time.
The reason people don't outperform the market: there are behavioral issues. There are agency problems. But it's not because we don't have those opportunities. I'll show you briefly -- let me tell you how we value stocks. It's not very difficult, and I think most of you will understand it. And I think the best example that seems to resonate with most people is thinking about buying a house. And to keep the numbers simple, let's say someone asks for $1 million for the house. They want to sell, and their job is to figure out if it's a good deal or not.
So there are certain questions that you would ask. One of the first questions I would ask is, well, how much rent could I get for that thing, okay? So, in other words, if you were to rent that million dollar house, how much would you charge for rent? If I were to collect $70,000, $80,000, $90,000 a year, 7%, 8%, 9% return on that house, that's one way I could value it. And what is the next question you would ask? I'm pretty sure I know what it would be. What are the other houses on the block, the next block, and the next town? How does this compare?
How relatively cheap is this, relative to all my current options? So that's what we do. We look at, how relatively cheap is this business, relative to other similar businesses, relative to a whole universe of options that I have? We do that. We also go back in history, we look at how this company or this house has traditionally been valued, compared to others in the neighborhood or compared to other communities. And how is it being valued now? So absolute and relative value measures, absolutely cheap in rent, relatively cheap in all the different kinds of measures that make sense to you, now, you wouldn't use any of these measures on their own.
If they just used relatively low prices, if some of you remember the internet bubble and bought the cheapest internet stocks, that wasn't cheap. It was just cheap relative to all other exorbitantly priced stocks at the time. But we use our absolute and relative value measures as checks and balances against each other to try to focus on fair value. So when you do this, I just want to show you a simple graph. This is actually a study that we did of our valuation methodology, very similar to the way I just said we value a home. Here's how we looked at the 2,000 largest companies in the US over a 20-year period.
This was from 1992 to 2012, and we rank them daily from 1 to 2000, based on their discount in our value assessment, using these metrics. The x axis here, you probably can't see it, it's just a percentile valuation. All of this means that if you were in the bottom left corner and in the first percentile, it's the 20 companies at any given time, out of those 2,000, that measure cheapest, according to our measures of absolute value and relative value. Go to the 99th percentile: that would be the 20 companies that measure the most expensive of those 2,000. The y-axis is the average annual return over those 20 years.
What this graph simply says is that, on average, the stocks that fell in our first percentile, the cheapest 20, averaged a one-year return over those 20 years of 38%. Stocks that ranked in our second percentile averaged a one-year forward return of around 37%. And then we come down to this line of best fit, which we always say we don't mind missing out on when we're making extra money. And then as we measure something more expensive, the year-onward performance drops. And if you were sitting in my class at Columbia and I said, hey, does anyone see a long-short strategy that you could follow if you could predict ahead of time which stocks would do best, second best, third best, in order, and you didn't say , I guess I would buy these guys here in the top left corner and short these guys in the bottom right corner.
If you didn't say that, I'd probably kick you out. of class, because it is very simple. That is what you must do. And by the way, that's what we do. The important thing to understand is that stocks are shares owned by companies, okay? Now, by the way, that beautiful graph I showed you with the 90% setting, why doesn't everyone do this? Well, unfortunately, it doesn't look like that when you're living through it. That's an average of 20 years. If I were to show you a fragment of three or four years, the fit would be good. It could be 0.55, 0.6, something like that.
But it's not going to be very cooperative, is it? If what we did worked every day, every month, and every year, everyone would. It would stop working, but unfortunately it doesn't. But the reason we stick with what we're doing even when it's not working is that graph, which means that the way we value companies, our measures of absolute and relative value, are roughly how the market values them over time. over time. If we were, say, momentum investors, that's fine, and I'll tell you that for those of you who know what that means, momentum has been studied all over the world for the last 30 or 40 years in the US.
It's worked pretty much everywhere, not all the time, but on average it's worked very well for 30 or 40 years, and not just in this country. But here's the problem. What if it didn't work for the next two or three years? It may be that we just have to be patient. It works over time, and it is cyclical. And that's why he's out of favor, and we just have to hold our ground because it's something that worked. Or it could be, if it didn't work in the next two or three years, that the explanation is, well, it's not that hard to understand.
A stock used to be down here, and now it's up here, it's got good momentum. And with all the data, and the ability to crunch numbers, computers, and studies that have come out, it's a saturated trade. It's degraded. It's not as good as it used to be. And if that's what happened over the next two or three years, I would know the answer to that question. I didn't know what it was. Should I be patient or has the trade degraded? But if you see stocks as shares owned by companies that you value and try to buy at a discount, and that doesn't work out for a couple of years, I'm not going to change what I'm doing.
I'm not going to buy the bottom right hand corner, I'm buying all the losing money and the companies that are making nothing or trading it 100 times, free cash flow. I'm not going to buy those, even if they work in a particular year, and then sell the ones that are cheap, relative to everything, get high rents and everything else. I'm not going to change my strategy, and I think stocks will eventually, not now, but eventually people will get it right. And you may have to be patient. That's really what I have to do. What that chart tells me is that I'm on the right track, which means that's our true north, and we just have to be patient to get there.
The reason these simple metrics don't arbitrage is that the example I usually use for arbitrage is, oh, you see gold in New York at $1,200 and it's selling in London simultaneously at $1,201. Well, some arbitrageur sitting at a trading desk somewhere will see that and buy gold in New York at $1,200 and drive the price up a bit. He will simultaneously sell gold in London at $1,201, pushing the price down. And they will converge somewhere in the middle, and it will happen asfast at a trading table you won't even be able to see that. But what if I told you that you could buy gold in New York today for $1,200 and sometime in the next two or three years you'll make money, but you could lose 20% of your money while you wait?
There's no guy sitting at a desk anywhere who can actually do that. And frankly, time horizons are getting shorter. Back when I was younger, I would get quarterly statements and most people would throw them away. Now you can check the price of your shares 30 times a minute on the Internet. Maybe some of you do. And the time horizons are shrinking, and we're just playing time arbitrage. We are being patient, buying good deals cheap and hoping the market recognizes the value we see. But it takes some work to value companies. And let's say you don't want to do that.
You have a day job. I guess everyone here has a day job so you don't want to do that. So one thing you could do is try to find someone good to do it for you, right? I am showing you that this opportunity exists. Maybe someone can do it for you. And what you should probably look for when you're looking for that person is someone who has a good investment process that makes sense to you. The problem is, for most active managers, if you think about their challenge: When they select an individual stock, they must think that they have a variant hypothesis for why that stock is priced differently than it should be.
And I can tell you, I've been doing this for over 35 years, and it's very weird. I have hardly ever bottomed out on a stock, I have bought it at the absolute bottom. So more than 99.9 percent of the time, a stock falls after I bought it. And there are really only two reasons why... one is that I was wrong. The other is that I just need more time for my thesis to develop, okay? Now, as an external assigner, you don't really know what the thesis for the individual action was. Even the manager himself sometimes does not know.
When things go against you, there are all kinds of agency problems. You have people to answer to. You have behavioral problems, naturally, you start to doubt yourself. Sometimes it is not very clear, even to them, what their prejudices are and what they are doing. They did studies that you're probably familiar with, why the home team always wins in sports, or at least wins more than it should. And the original thesis was generally, oh, they're used to court. They slept in their own bed. The fans, they cheer them on, whatever it is. And when they controlled for all these variables, the answer turned out to be that refs don't like to be booed, okay?
So they don't think they're being biased. I'm sure 99.9% of the time they don't, but they don't like to be booed. And so they're being influenced by... and then there's the same problem with an active manager. He has behavioral issues at the agency that he's not sure about. So the assigner doesn't really understand the thesis behind each selection. It is not clear that the manager is totally impartial when he has a variant thesis that goes against him. And since you don't know the thesis as an allocator, most people... all they have is the returns, and that's what they used.
So in an interesting study that came out the day after Thanksgiving, it was interesting to me, probably not interesting to the guys who did the study. Morningstar published a study of its star system. And its star system is based on past performance, letting you know who has done better in the last one, three, and five years. Of course, my interpretation of his study was that our star system is broken. We cannot discern. The last, three, five years of returns doesn't have much to do with the next, three, five. But that's what everyone uses. I wrote a
I hold it here. It's called "The Big Secret," and I always say it's still a big secret because nobody read it. And in that
book, I talked about some studies. Number one, I was talking about the top performing manager. I wrote it in 2011, so I was talking about the 2000s to 2010s -- it looked at the best-performing mutual fund, a study of the best-performing mutual fund for that decade. That fund was up 18% per year, 100% long US stocks. The market was flat for those 10 years, so an increase of 18% per year is pretty good. Unfortunately, the average investor in that fund, on a dollar-weighted basis, managed to lose 11% per year because every time the market went up, people piled on.
When the market went down, they piled up. When the fund outperformed, they piled up. When the fund underperformed, they piled up. And they took an 18% annual gain and turned it into an 11% dollar weighted annual loss, why? Well, to beat the market, if you're leading by 18 points, you're doing something different from the market. You're going to zigzag differently. You cannot do the same as the market. You have to do something different. You're going to zigzag differently. Institutional managers are no different. These are the statistics on -- if you'd just take a look at the top institutional managers of that decade, the ones that -- from 2000 to 2010 -- the top quartile managers, the ones that ended up with the best 10 years. record, here are the stats on them. 97% of those who finished with the best 10-year record, the top quartile, spent at least 3 of the 10 years in the bottom half of performance; not surprising, but everyone, right?
To beat the market, you have to do something different. You're going to zigzag differently. 79% of those who finished with the best 10-year record spent at least 3 of the 10 years in bottom quartile performance. And here's the amazing thing: 47%, about half of those who finished with the best record, but spent at least 3 of those 10 years in the bottom decile, the bottom 10% of artists. So, nobody stayed with them, but they finished with the best record. So it's very hard to pick an allocator, because he doesn't know the thesis, so he's using past performance. But when you do that, all you do is chase your tail, going in and out at the wrong times, so it's very difficult.
What a good mapper, usually an institutional mapper, and there are a few of them, you should be looking at the process, and you stay with your process. But of course there are agency issues on the allocator side, because even if you're on a really good investment board, and you're an allocator, and you're the US equity director, or you're the director of alternatives or bonds, or whatever, you have a point of reference. And if you haven't beaten your benchmark for the last three years, I'm not saying in the good places, they kick you out. But I'm saying you don't have a parade, okay?
So it's very, very difficult on that. So one thing you could do is do it yourself. And I wrote this other book that you have, "The
beatsthe market." And I just made a simple formula that was like jelly beans, counting the rows, traversing, and selecting the cheap companies to buy, very simple. And I wasn't handling outside money at the time I wrote the book in 2005; I just wrote the first study we did on how to make something cheap and good. The companies just made it easy for you to buy a handful of those.
And I kept getting phone calls…hey could you do this for us? So what I did was I created a website that listed the top actions. It's still around, MagicFormulaInvesting.com. And people were like, yeah, okay. But could you still do this for us? So I installed something called the investment formula. And I gave people two options. I said, well... I saw it as a benevolent brokerage firm. I said, listen, we'll let you do this yourself. But you have to choose from this main list of 30 or 50 stocks, and you have to choose at least 20 of them, okay?
Stay out of trouble, and you're supposed to invest every quarter, refresh your portfolio, and do this mechanically. You don't have to buy everything, but you do have to buy at least 20. And then the person who was in charge of this for me said, you know what? How about just adding a checkbox that says, just do this for me, just buy it automatically? So as an afterthought I said ok. We will do that too. We did this for a couple of years and let me tell you the results. People who chose their own stocks from the pre-approved list of top stocks did pretty well.
Over the two years, they increased by approximately 59%. Unfortunately, the S&P was up 62% over those two years. The automatic, just do it for me: That's up 84%. So the automatic had beaten the… in other words, just buying the list had beaten the market by 22 points. But by giving people discretion, even though the list was pre-approved, just picking and choosing the ones they didn't like, but they had to buy at least 20, they managed to get a 22-percent return in a couple of years, which is pretty good, and turning it into a poor 3% return. So do it yourself. I wrote an article for Morningstar called "Adding Your Two Cents Can Cost You Big." And so I just wanted to point that out.
So the other way-- let's see, I'll make it quick. I wrote a book mentioned, called "You Can Be a Stock Market Genius." Worst headline in the world of all time, but in it it said something like Warren Buffett calls, why don't we just look for one foot hurdles, okay? And I opened the book with a story about my in-laws, who used to spend…had a house in Connecticut, and they used to spend their weekends going to garage sales and country auctions looking for bargains, okay? Paintings or sculptures: they were art collectors. And I described what they were actually doing.
And they didn't go to these yard sales and country auctions looking to see a painting that got thrown out, saying, this guy is the next Picasso. That's not what they were doing. What they were looking for are pieces of art or sculpture that know the artist. Some of their similar work had just come up for auction for much more than they could buy, right? They could buy it for 30 or 40 cents on the dollar for what just came up for auction. That is a very different question. And so "You Can Be a Stock Market Genius" was to show you these areas that are being ignored.
These are the field auctions and garage sales of the investment world. And these were… I talked about different areas, spin-offs, bankruptcies, small-cap stocks, recapitalizing companies, anything weird, sticky situations. That's another way, but you guys have a full time job. That's a full time job, let me tell you... it's a full time job. So right now we run mutual funds. I can only tell you about some of the struggles we have with investors. We followed that chart, we picked from the 2000 largest companies, and we've had a good track record. But there are years like 2015 where there is a benchmarking problem, which means that the S&P 500 in 2015 was up about 1.3%.
The equally-weighted Russell 2000 was down 10. The equally-weighted Russell 1000 was down 4. So if you're picking from the top 2,000 or so stocks, an even return would be 6 or 7 down, not 1.3 up. So there's a benchmarking issue, but to beat the market, you have to do something different. You are going to zigzag. They all know that. Now we're working on something -- we've had something open for a couple of years where we say, okay, we'll start with the benchmark and then add value. And we'll make some compromises so that we don't, it's called Index Plus, and so that we don't stray too far from the index.
So you can stay with us, and the thesis was basically... the best strategy for you, which is how I'll end before I answer questions, is not just one that makes sense, but one that you can stick with, okay? ? So you have to understand what you're doing, number one. If you give it to another person, you have to understand what he is doing. And you have to be able to stick with it, so you have to understand it well enough to stick with it. So that's, I guess, before he answers the questions that I'll leave you on.
And maybe... SPEAKER: Yes, thank you very much. That was great. So let me put the chairs. So thanks again. Reading his book of magic formulas, "The Little Book That Still Beats the Market," I noticed that he mentioned that there were questions about whether to short the most expensive stocks through the same metrics. And I assume you hadn't explicitly said that's the way you'd like to go. And correct me if I'm wrong. And then he also started the fund investment formula, which he alluded to in his talk. However, what has happened to them? Are they still going, and what is your vision for the future?
JOEL GREENBLATT: Sure, we open only long funds, called investment formula. And we just merge them with our long-short funds. So we have long-short funds that are 100% net long. But when we looked at their performance, we did better in marketsbullish with 100% long, long-short funds. We had a long-short overlap in bull and bear markets. More or less, we never did better any other way. So we merged our simple 100% long with the 100% long which was also long-short. So it was just a matter of trying to do our best and managing things. In fact, we just received the number one fund rating, five stars from Morningstar for our formula mutual fund, and closed it.
And we merge it with our long-short funds. It wasn't really a business decision. It really was a decision that we want to do our best. And that's why we did that. SPEAKER: So when you talk about the long-short term, how do you decide between the 1/70/70 spread or the 1/40/40 spread? When you say you're 100% net long, how do you arrive at the ratios that they should be? JOEL GREENBLATT: Sure, so what you're saying is that… well, what you mean is, let's say you give us $1. We will go buy $1 of our favorite stocks. Then we'll go out and buy $0.70 more of our favorite stocks, but this time we'll combine it with $0.70 of our least favorite stocks.
We'll shorten them, so we'll be 70 long and 70 short, and so another cube to add return. And why isn't that 40/40? We chose ratios for most of our funds that we thought made sense given the volatility added by how much leverage you are adding and how much you are cutting. There is no great magic in it. Something that worked well at $1 long with 70/70 or 40/40; both work fine. In our large-cap universe, we give people choices. SPEAKER: Mm-hmm-- so Joel, there are a lot of questions on the same topic. I guess we can pack them into one. People are curious to know, what do you think of the market valuation today?
Where do you see areas of value today? JOEL GREENBLATT: Well, the benefit of having... we have a great research team and we have a lot of history... if you want to think about the S&P 500, those 500 companies. So we go back 25 years and we look at each individual company every day for the last 25 years and add them in the weights of the S&P 500. So what that allows us to do is look at today: where is the valuation of the S&P 500 today? , contextualized, versus the last 25 years? So what I can tell you is that we are at 17, it is not a prediction.
I'm just giving you some facts. The way we value companies, we're in the 17th percentile for expensive over the past 25 years. That means the market has been cheaper 83% of the time, more expensive 17% of the time. When it's been here in the past, the year-over-year returns have not been negative. During those 25 years, the market has risen 10% per year. So right now at these valuation levels, what's happened in the past-- over the next year, an increase of 3% to 5% on average; in the next two, up to 8 to 10, so like I said, it's not a prediction. But if you want to know what happened to stock prices at similar valuation levels over the last 25 years, here's what happened: 3% to 5% positive return on average over the next year, and 8 to 10 over the next few years. next two.
SPEAKER: So there's a question about what you were doing in the first 10 years of investing, when I think you averaged 40% to 50% annual returns after fees. Correct me if I'm wrong. What was the strategy that you and Rob Goldstein were following in those days, and what parts of it are actionable for the individual investor, compared to the Index Plus strategy? JOEL GREENBLATT: Sure, so investing in stocks is finding out how much a business is worth and paying less, and that hasn't changed. What makes a company worth something and what makes it cheap relative to that is pretty straightforward.
That's kind of like Ben Graham: find out how much it's worth, pay a lot less, leave a big margin of safety between those two. Warren Buffett added a little twist that made him one of the richest people in the world. He simply said, if you can buy a good deal cheap, even better. If you read Buffett's letters, it's pretty clear what he's looking for. The first thing he's looking for, however, is businesses that have high returns, we call it, in tangible capital. And that just means that all businesses need working capital. Every company needs fixed assets.
How well do you turn your working capital and fixed assets into profit? So the example that I used in "The Little Book," which I actually wrote to explain these kinds of concepts to my kids: I said, imagine you're building a store and you have to buy the land, build the store, set up the display, carry it with inventory. And all of that cost you $400,000. And every year, the store generates $200,000 in profit. That's a 50% return on tangible capital. Maybe I should open more stores, not as many places where I can reinvest my money at those rates. Then I compared it to another store.
Remember, I wrote this for my children. And I called that store Just Broccoli. It's a store that only sells broccoli, and that's not a very good idea. Unfortunately, you still have to buy the land, build the store, set up the display, stock it with inventory. That will still cost you roughly $400,000. But since it's kind of a stupid idea to sell broccoli at your store, you might only make $10,000 a year. That's a 2 and 1/2% return on tangible capital. And all I'm just saying is that I'd rather own the business that can reinvest your money; All things being equal, I'd rather own the business that can reinvest your money at high rates of return than much lower rates of return. .
And that's kind of a Buffett twist that we bring into the companies that we invest in, being very tough on how companies make and spend their money. So we tend to get a bunch of companies that are not only cheap but also deploy capital well. And that's really what we're looking for. So we've always done that. "The Little Book" was more of a way of systematizing that. But in "You Can Be a Stock Market Genius," what did we do in the first 10 years? I wrote a book about it. It was "You can be a stock market genius." I was looking for things out of the ordinary, more complicated that other people weren't looking at.
Something strange or different was happening. I showed people nooks and crannies in the market, where they could look for them. The problem there, and there is no problem. It's big business. But our portfolios were 6 or 8 names, they were 80% of our portfolio. We returned half of our external capital after five years. ANNOUNCER: Five years. JOEL GREENBLATT: We returned all of our outside capital after 10 years-- SPEAKER: 10 years. JOEL GREENBLATT: Between '85 and '94, we were lucky to have enough money to support our staff and continue to manage our money thereafter. Warren Buffett said that a fat wallet is the enemy of high investment returns.
So when he has a very concentrated portfolio and he's looking off the beaten path, where there are smaller situations and things that are more obscure, he has very limited liquidity. That's why we keep giving money back, but that's not why we're doing what we're doing now. If you're going to run with other people's money, this is what I'll tell you with a portfolio that has 6 or 8 names that are 80% of your portfolio. Every two or three years, usually within two, Rob and I, my partner, Rob Goldstein, and I would wake up to find that we just lost 20-30% of our net worth.
And it happened like clockwork every two or three years, it just happened every time. It has to happen with a concentrated portfolio, either because we got one or two of our picks wrong, or because the market fell out of favor over a period of time. And maybe it bothered us, maybe it didn't, if we just had to be patient. But I would say outside, when you were talking about people going in and out of funds and missing their turn, that's not conducive to other people, especially if they're not doing the work. It was good for us, and I think it was good for us because we knew what we had.
And as long as the facts hadn't changed, and as long as we believed in our thesis, we could take that. I wouldn't say it was easy, but we could take that. Now, our bad days, we have hundreds of shares on the long side and hundreds of shares on the short side. We are trying to be correct on average. We are buying cheap and good companies. We're shorting companies that are destroying capital, or losing money, or whatever. And over time, that pays off. But our bad days, with hundreds of stocks on the margin, are 20 or 30 basis points of underperformance, not 20%, 30% of our net worth.
And I think for most people, it's a calmer ride. And one of the great lessons that young investors, and many of you are still very young, can learn is compound interest tables. If you can get mid-teen returns, you wouldn't get 40% or 50% annualized returns, but in mid-teen returns, if you know compound interest tables, you can do very well with a smoother ride over a long period of time. One of the best examples, and when I taught those 9th grade students, I actually put the outside of their notebooks on, I handed them notebooks. And I, on the outside, had a compound interest table.
And I had the example of starting to invest $2,000 a year when you're 19, in your IRA, until you're 26, so seven years of saving $2,000 and never putting another penny back, or starting when you're 26 and putting $2,000 a year for 40 years, until age 65. So people who put in $2,000 a year from age 19 to 26 and never put another penny in ended up with more money if they earn 10% a year on that money. They ended up with more money from those seven payments than people who start at 26 and make 40 payments, all the way to 65. You end up with more money, from 19 to 26, just a very important lesson to learn about getting started. early.
I know all of you are over 19 so I'm sorry I didn't tell you this. But these children were not, so the compound interest tables are important. So you're young, if you stick with a very methodical investment strategy that makes sense over time, everyone can do very, very well. ANNOUNCER: So, Joel, thank you. You've talked about the size effect, right? Going into hidden places and dark areas too: He also talked about the temperamental edge it can bring to the investing process. And then there is something to be said for the analytical and informational edge. And there used to be a lot of net net payback investment.
And do you think some of these edges have become less relevant, rather than more relevant, over time, with information almost universally accessible? JOEL GREENBLATT: Well, information... people have information about S&P 500 stocks. There's still a lot of groupthink going on. What I tell my students is, some of these smaller caps -- you know what happens if you're really good at doing things, like reading "You Can Be a Stock Market Genius" and buying some of these things in these dark places. . And what I would call is taking unfair bets, not because you're so smart, but because you found it in a place that other people aren't looking for.
What happens to people who get good at it is they get a lot of money and then they can't do it anymore because they have too much money. So it opens up a whole new area for young people to continue to get into that. So certainly some of the smaller situations will always be there. Things can be a little more streamlined, but there's been a lot of studies that, one of the big chapters that I wrote was on spin-offs, which are companies that are separate from, and still do very well. But somehow it fails: they have studied, if you bought all the spin-offs, how would you fare?
And they keep getting better. That's not really the question. The question is, is this an area ripe for mispriced stocks? If the average spin-off was average, that wouldn't mean anything to me. You're looking for the opportunity where people discount things or just aren't interested in things for reasons other than the merits of the investment. They may be too small. It may not be the company that the people who owned the original shares invested in. Companies that are in disgrace at the time are usually dropped. So though on average they have continued to outperform just as well as when I wrote the book, so that's not discouraging.
But even if they were average, they're still ripe for mispricing, really what I'm looking for. So you're looking at these areas that are ripe for price manipulation. You don't need to run a statistical model to decide if, on average, they're doing well or not. If you know what you're looking for, you're looking for opportunities to find things that are mispriced. And I don't think they will go away. But like I said, there are higher and better uses for most people's time. So I had a lot of fun doing that. I have a ball doing what I'm doing.
If you don't want to do it, that's fine. SPEAKER: In one of your interviewsrecent, I think he mentioned Apple, one of the big companies. And he believes that groupthink and mispricing can happen even in large companies. So maybe Apple or some other company… I was wondering if you could take our audience through an example of, what are the metrics one should look at if they were looking at a company? JOEL GREENBLATT: Well, I'll take Apple as a big picture. Have you heard of that? So at least I'm old enough to have owned a BlackBerry. And it used to have 50% of the market.
Now it really doesn't exist. It wasn't that long ago. And the vast majority of Apple's profits come from its phone. That's Apple's negative story: it's a hardware company. It's going to crash and burn like all of them, okay? On the other hand, some people might say, oh, you have an ecosystem of products that complement each other. They interact with each other. It has a mark. I always say, hey, Coca-Cola doesn't make sugar water, and they've held their brand pretty well. People tend to like Apple as a brand. And so the question is, what is it? Is Apple a hardware company or is it an ecosystem of products with a great brand name?
I'd say the answer is probably grey, somewhere in the middle. It is none. It's probably somewhere in between those two. But if you took a look at the market, I can see where the S&P is trading. I can look at where Apple trades. And a few months ago, it's still dirt cheap, but a few months ago, it was trading at less than half the valuation of the S&P. So at a price, my answer is, if it's somewhere in the middle, I'd say it's probably better than average. And I'm getting it for half the price.
I don't know if that's the case, but I have a large margin of safety. I have hundreds of... what I'm saying is, what we're doing now is I don't know the answer to your question. It's gray. I don't know the answer. I don't know if it's closer to a hardware company. I don't know if it's an ecosystem with a brand attached to it, so it's much, much better. But interest rates are 2%. Has a free cash flow yield of 10%, earns a high return on equity. It has a great niche. What I would say is I don't know if Apple will work, but I don't just have Apple.
I have a bucket of apples. I own a bunch of companies with metrics like that: trading very cheap, good capital deployment, good potential prospects. So, I don't know if Apple will work. I know my bucket of apples will work. That was the chart I showed you. And so we own the bucket of apples. But if you ask me my bet on Apple, I think it's cheap, compared to other options right now. SPEAKER: Great, I just have a couple of questions, Joel, quick. You mentioned the index fund at the beginning of your talk. With all the money flowing into passive funds, ETFs, and index funds, what would their countermoves be during a period like that?
Are there things that investors should be cautious about, for example? JOEL GREENBLATT: Well, I told you that I thought the market as a whole -- it's a market capitalization-weighted index, the S&P 500 was expensive, but I still expected positive returns going forward. It is a world of alternatives. So the question is, how should I invest my money? The move to the passive can, with all the ETFs and everything else, can cause dislocations in the short term, because people aren't perceptive. Remember, I said that stocks are not bouncing pieces of paper, on which Sharpe and Sortinos indices are placed.
They are stocks owned by companies, and companies: there is a dispersion in their fundamentals, how one is doing, versus another. When you only pick one ETF and don't discern between differences in fundamentals, that can cause short-term dislocations. That makes me smile more because those dislocations mean I can find bargains because people stopped thinking. But I don't think they will get to that point, except in the short term. I think you're familiar... when the market falls and everyone gets depressed at the same time, they say the correlations go to 1. That just means everyone throws the baby out with the bathwater.
They do not discern. But that really only happens for the first month, maybe two at the most. And then there begins to be discernment. That's actually the best moment of opportunity for us, when people start to discern again. And you just made everything move together, which it shouldn't. They all have different perspectives. And the same with ETFs, if there are flows into them or the indices, that could cause short-term dislocations for a month or two, but they correct over time. As I said, the market finally gets it right. There's a lot of-- just think of the jelly beans.
You really get it. It's the gummy effect of when everyone listens to what everyone else thinks. That happens most of the time. That is what the stock market is. Your job is to be cold, calculating, and unemotional. Unfortunately, people are human. It's good news for us, but folks... the statistics are against you. That's why I think indexers are right for the wrong reasons. They mostly say that the market is efficient and have other explanations why you can't beat it. I think that the market often gives you opportunities, but it is very difficult to take advantage of them due to behavior and agency problems.
And those are so much more powerful than you'd think by just saying, oh, behavioral and agency issues. People are people, and it's been going on forever. I don't think it's getting better. I think time horizons are getting shorter. There's so much… all that data, all that… look, when I started my first company in 1985, I used to write quarterly letters. And they read something like this: We're up 3% last quarter, thank you very much. That's what it said. Now we have endowments of $10 and $20 billion that we need to get our results on a weekly basis. I don't know what they do with them.
But now we have to do that, and most of them do it well. But that's the way the world is. So if you keep measuring things in shorter periods, and you can measure them, and there's more data, you don't do better. It makes you more susceptible to emotional influence. So that world is getting better. The last man standing is Patience. We call it time arbitrage. Other people call it time arbitrage, just be patient. That's very poor, and it's not getting better. Things are moving faster and with less patience. So that's really the secret. So now you don't even have to read the big secret.
SPEAKER: I think a fantastic gift that you have given to the value investor community is the Value Investors Club. I'm sure most of the people here have already visited the website. If you haven't, please check it out. It is an amazing resource. Joel, if you could say a few words about Value Investors Club, what is your vision for the future? And how does it compare or contrast with other investment platforms that are emerging these days? JOEL GREENBLATT: Sure, well, it originally started in 1999. And the whole thing with the Internet back then was getting millions of eyes to watch.
And I saw it more as, wow, I always wanted to be in an investment club. And I thought, well, I could form an investment club where you can meet at any time, at your convenience, wherever you are, and share ideas and back and forth about it. And I'm always grading papers at Columbia for my students. And at the time, there were Yahoo message boards where 99.9% of the stuff wasn't worth reading. So I said, hey, why don't we -- along with my partner John Petry, I said, why don't we look into people who can join the Value Investors Club?
And if I had gotten… maybe two or three people in the class each year would get an A-plus. And if you could write an investment thesis that would have given you an A-plus in my class, you can join the club, and it's free. All you have to do is share your best ideas. You get to share a couple of your best ideas over the course of the year, and that entitles you to see everyone else's good ideas. And so it's just based on merit. And still, only 1 in 20 applicants get in, so I think it's a little harder than Harvard.
I don't know. But it's been running now for 16 years. We have a-- I think it's a 45 or 90 day backlog that if you're not a member, but to get things live, you have to be a member. So learn to value a business and apply if you want. There are instructions on the website. It's called the Value Investors Club. But as a learning tool, I always refer people there because they are very smart investors. They hit each other. There's a Q&A after they post something and they're like, what's up with this? What about that? An excellent rating out of 10 is a 5, because they're all bad and very... they're value investors.
They are very tough and stingy. And so they don't, so if you look at the ratings and you see something 5 or higher, that's good, these guys. And you can look at that. It's just a learning exercise, right? It's teaching a man to fish. That's really how to be good at investing. It's nothing else. You have to understand what you are doing. It is a great way to learn. So I think for the next generation, it's a good way to teach them to look at what smart investors are doing now, it doesn't mean I agree with everything on the site.
And this is a good point. I'm probably wrong more than I'm right in transmitting things. But Warren Buffett calls it walkouts on Wall Street. You could let 100 pitches go by and you should have swung at 30 of them. But if you just pick one and make sure it's a good one, that's really the way we invest. I just have to... my partner Rob Goldstein and I are very hard on each other. So we both have to like it. We both have to argue our points. And if we both like it, we think it's pretty good. So we're really picking our releases.
It doesn't mean we don't miss out on a lot of good ones. It doesn't matter if we miss them. It only matters that the one we choose is good. And that's pretty much the "You can be a stock market whiz" type of investing way of thinking. What we are doing now in our long-short portfolios is being more right on average. I showed you that chart where we're pretty good at valuing companies. So we bought a group of businesses where we have a bucket of apples. And we are missing a group of high-priced companies. Let's go short on some things that lose money, or the Teslas and Amazons of the world, selling for 100 times free cash flow.
And people get confused, because that's what I call the tyranny of the anecdote. It is that we will shorten some incorrect ones. We won't cut much of them, but we will cut some, and we will be wrong. And you will know their names because those were the winners. But if you are missing hundreds, believe me. It is not a good idea to eat all the cash, lose money, or sell at 100 times the free cash flow. And generally, if you're generating a lot of cash, and you can buy it cheap, and they're deploying your capital well, that's a good thing to do.
And so we're trying to be right on average. Two different ways to do it, doesn't make one better than the other - there are different ways to make money. I love both, would do both again. Both are full time jobs. SPEAKER: Great. And, Joel, our final question goes perhaps one step further in the assessment. In his books he has talked about different types of multiples that are used to value companies. He's talked about business value for free cash flow, for example, EV to EBITDA is one of those multiples. And many of those multiples, he says, have proven effective for long-term investing, whether you're buying a bucket or a basket.
However, the question is that due to the lack of a single source of accurate reference markets (because there are one-time charges and things you have to clean up for), there are many sites on the web that claim a wide range of numbers. . Some good, some not so much. Has he thought about having a standardized implementation, perhaps open source, to compare these metrics over the long term, in the same spirit of the investment magic formula, for example? JOEL GREENBLATT: Okay, I think I'm a nice guy, but not quite. So we have a team of analysts. We review every balance sheet, income statement, statement of cash flow at the companies we look at.
What is that deferred tax asset, or pension liability, or off-balance sheet plant in Taiwan? How should we handle that? How efficient are they in using and spending money? We do all that work. When I wrote "The Little Book," I called it the Don't Try Too Much method. It worked amazingly well using rough metrics, the guy you're talking about, rough metrics, and it worked amazingly well. My partner Rob and I looked at each other and said, this just didn't work well. It worked a lot better with those, without trying too hard, than we thought. Can we improve that?
In fact, we know how to value companies. Can we go do that? And we put together an investigative team, and we do it. It would be great if I shared it with everyone, but it's a lot of work. And the other way works amazingly well. SPEAKER: You're a good guy. JOEL GREENBLATT: I'm a nice guy, so we're trying to treat our customers very well. SPEAKER: On that happy note, thank you very much, Joel. It has been a pleasure. JOEL GREENBLATT: Thank you very much. Thank you.
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